In 1997 the US money market fund (MMF) sector had assets under management of $1trn (e770bn), compared with $7bn in Europe. By 2004 the US sector exceeded $2trn, while European funds were valued at $205bn. “I think there is scope for the European industry to go to $2trn as well”, says Chris Oulton, head of UK money market sales at Insight Investment and chairman of the media committee of the Institutional Money Market Fund Association (IMMFA).
Sterling growth has been sufficiently dramatic to merit a feature in the Bank of England quarterly bulletin in summer 2004. “The growth of sterling institutional money market funds
has the potential to change the flow of funds in the sterling money markets and to alter the composition of banks’ balance sheets”, said its author, Adrian Hilton. (see www.immfa.org.)
A significant factor in the growth of these vehicles is their increasing use by pension funds and other institutional investors as a home for short-term liquidity, in a move away from the more traditional use of bank deposits for this purpose.
The explanation for this is not hard to find. It is done “for fiduciary reasons as often as not,” says Oulton. “Pension funds spend a lot of time drawing up mandates according to complex investment principles and making sure that every aspect of the scheme is OK, only to find they have left maybe 10% on the balance sheet of the custodian,” he explains.
In the past, says Morgan Stanley executive director Nick Hoar, “pension funds typically left cash with the custodian – so they were exposed to the credit rating of the custodian”. Since few banks now have an AAA credit rating, a move to an AAA-rated fund improves the security of what could be a very large tranche of cash. “A well diversified liquidity fund with a good credit rating offers returns which are comparable to deposits and a rating which is better,” says Andrew Dickinson, head of the short duration team at Credit Suisse Asset Management.
There are also advantages of convenience with the MMF route. Hoar points out that managing money on deposit means rolling it over at the end of the deposit term even if access to the cash is not needed, or sustaining a penalty for breaking a deposit period if it is needed prior to maturity. Investors need to “park money in a safe vehicle, be able to get at it instantly, and not need to focus on it every day”. All this is available in MMFs, he says.
The trend towards using MMFs rather than deposits is related to a new recognition of the need to pay as much attention to liquidity as to the asset allocation of the entire portfolio.
James Finch is head of the financial institutions team in the liquidity funds division at JP Morgan Fleming (JPMF). As he points out, a pension fund might have cash holdings valued between 3-5% of the fund. “That represents a large amount of free cash – and management of that cash is critically important. Historically, there was a perceived need to sweat cash for yield. Nowadays, pension funds are realising that they cannot afford to leave decisions about this cash to the fund manager or the custodian. They must pay attention to it themselves.”
Hoar reinforces the point: “The last thing a pension fund wants to do is lose money on cash. The preservation of capital is paramount.” The growing consensus on this view among pension funds is driving the move into MMFs. “A raft of pension clients are now saying they want to be in a fund,” says Oulton.
James Finch sees a need to “educate people about what we mean by an AAA liquidity fund”. IMMFA was set up to represent the managers of AAA funds in the European market.
These are funds of the highest credit quality designed specifically for short-term liquidity use. In the giant and much longer established US industry, such funds are strictly regulated by the SEC under the SEC2a-7 regulations. The aim of IMMFA was, “through voluntary self-regulation to have an industry as secure and transparent as in the US. We see security and stability as paramount ahead of any performance considerations”, says Oulton.
Rated funds in the European market are covered by the rating agency requirements, which, in the case of AAA-rated funds, are actually stricter than SEC2a-7. They also operate within the rules of local regulatory authorities and the UCITS legislation. “Most pension funds want to see at least two triple A ratings,” says Hoar.
AAA funds hold no instruments with maturities of longer than three months, and no floating rate notes (FRNs).
A section of MMFs outside the sphere of IMMFA consists of lower rated funds sometimes known as ‘enhanced’ funds. These offer slightly higher yields in exchange for greater credit risk. There is not as yet wide take-up of such funds, but they may have a growing place on the cash management spectrum.
“Some MMFs are not rated because they feel the rating criteria are too restrictive”, says Dickinson. CSAM’s Luxembourg funds are not rated because the fund manager wants to hold FRNs and securities with maturities in excess of one year. Their holdings still offer a good credit risk “with returns which are 30 basis points over the deposit rate – which would not be achievable under the Moody’s or S&P criteria”, he adds.
Hoar estimates the percentage of pension fund money in AA or lower rated funds as only 5% of the total, but at JPMF James Finch sees “growing interest” in enhanced funds. “The underlying cash in a pension fund is not as volatile as that of many corporate users, so we can add value by blending enhanced funds and liquidity funds in the portfolio,” he says.
It seems that the performance possibilities offered by AA funds may be an attraction, particularly in continental Europe.
Hartmut Leser, managing partner at German consultancy Feri Institutional Management, feels that though the German pension fund market may be a bit behind in the adoption of MMFs, “performance pressure on institutions is high in Germany, and pension funds will use every possible measure to increase return. MMFs may be one of those means”.
For Leser, the driver of the trend is the “performance issue”, so he expects that take-up will not be limited to AAA funds.
Local groups are beginning to launch funds making use of commercial paper, and Leser expects interest to build. “Once pension funds get presentations from whoever is offering it, they will start to think about it,” he says.
Jeroen Tielman, CEO of Dutch consultants FundPartners, also feels that “AA can work as well”. Tielman sees MMFs as “more and more accepted by pension funds as an alternative to deposits”.
One advantage MMFs have, in Tielman’s view, is their greater transparency and accessibility to smaller institutions. Whereas the rate of return on bank deposits is “a market of negotiation”, with all the advantages on the side of the biggest pension funds, MMFs do not hang their return rates on critical mass, so smaller funds have a fairer deal.
JPMF’s perception of the growing trend towards MMFs is reflected in the fact that it recently divided its relation management team into separate arms to deal with corporate clients and other financial institutions. “Pension funds and asset managers have specific needs we need to align ourselves with. It’s a more complex decision for them”, says Finch.
Quite apart from the perceived growing need for MMFs in European fund markets, a possible US tax change could affect assets under management figures in the near future.
Currently a lot of ‘dead money’ is held in the European MMFs of US providers, which deal extensively with US-based corporate multinationals. Because of tax rules which impose corporation tax at 35% when the money is repatriated, corporates have tended to park money in MMFs over a number of years, making few withdrawals.
A bill currently awaiting President George W Bush’s signature would result in the tax being reduced to 5.25% for a one-year amnesty period – perhaps resulting in a major haemorrhage of cash, and giving providers a powerful incentive to market to European institutions rather than US corporates.
But this factor aside, MMFs for short-term pension fund deposits seem to be a growing trend. Oulton concludes: “There are good signs that these funds are getting adopted in the way we had hoped.”